The Treasury curve flattened significantly for a second straight week, hitting new cycle lows, as yields ended mixed across the curve. 2’s-30’s moved 11 bp lower on top of the 12 bp flattening of the prior week, to a cycle low 87 bp, as the 2-year yield rose 4 bp (including a marginal roll into the new issue), to 3.65%, and the long bond yield fell 6 bp, to 4.52%.
The 3-year yield was flat on the week at 3.71%, leaving 2’s-3’s at a remarkable new low of only 6 bp. [There you have it. The 2's-3's will be the first to invert and and may do so shortly after the hike tomorrow. - Mish]
The implied 1-year rate 2 years forward given by this spread indicates either extraordinary pessimism about the growth outlook over the next couple of years or a high level of investor complacency. The 5-year and 10-year both also performed strongly on the curve ahead of Wednesday’s supply announcement, with the yield on the former down 2 bp, to 3.90%, and the yield on the latter down 5 bp, to 4.20%. After some significant gyrations as investors flipped back and forth between focusing on growth and inflation risks and tried to figure out whether the Fed might be shifting from thinking more about the former, Fed pricing in the futures market did not end the week much changed heading into Tuesday’s Federal Open Market Committee meeting. A 25 bp hike on Tuesday is fully priced in, while a 0.5 bp rally in the July fed funds contract, to 3.235%, priced in a slightly higher, but still small likelihood of a pause in June.
The market and the public rhetoric from the Fed continue to diverge drastically beyond June. The October fed funds contract ended the week flat at 3.55%, still pricing in a high probability of a skipped rate hike at either the June, August, or September meeting. Meanwhile, the June to December 2005 eurodollar spread flattened 1.5 bp, to 51 bp -- pricing in only two rate hikes at the four FOMC meetings in the second half of the year -- with the June contract selling off 1.5 bp, to 3.425%, and the December contract was flat at 3.935%. Very little, if any, additional tightening is expected in 2006, with the December 2006 contract rallying 2 bp, to 4.335%.
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